It seems as simple as a handshake. An investor buys into a company, becomes a partner, and shares in the profits. The company's success benefits everyone involved: owners, investors, employees, families, suppliers and customers.
Yet in Latin America, it has taken a decade of hospitable macroeconomic trends to give investors the comfort level to start buying equity in the region's small and medium-sized businesses. Commercial banks often consider these young, small companies too risky, and many investors still see Latin America as an emerging market. But a handful of venture capital funds today are buying shares and looking to the future. They see virtually untapped investment potential: thousands of innovative businesses waiting to be capitalized and ready to grow.
"A developing economy needs good products and creative entrepreneurs if it wants to compete globally, and both of those usually come from the small and medium-sized business sector," says Andrés Blondet, who heads a venture capital fund in Peru, where 75 percent of the top 5,000 companies have gross sales of less than $2 million. "That's our market. They're the ones who create the new products to trade, sell and export."
Equity investment holds several advantages for small, young companies. Unlike bank credit, it does not require collateral. It also does not require companies to start paying dividends until the business is developed, freeing them from servicing debt right when they most need capital to build their businesses. Moreover, venture capital funds can bring a wealth of contacts and expertise, ranging from financial know-how to marketing, that can help businesses cope in the critical years of growth and expansion.
"I think venture capital is probably the only attractive funding source available for these kinds of businesses," comments Jerry Barnes, CEO of Mesa International, a U.S. wholesaler that imports from Latin America. "Banks love you when you have a lot of money; venture capital respects you when you don't. And it's willing to take the risk of investing in your company."
So new is venture capital in Latin America, however, that fund directors often find themselves having to explain why and how they're going to invest millions of dollars in local companies. They hold workshops, they take out newspaper ads, they work through business associations. The Fondo de Asistencia a la Pequeña Empresa (FAPE) headed by Blondet is Peru's only venture capital fund for the small business sector. Founded in 1997, FAPE has already made five equity investments and expects to make 55 more over the next decade.
"Most entrepreneurs have no concept of venture capital, so we have to explain it to them," says Blondet. "What gets them really excited is not only the financing but the partnership idea. What makes them think twice is the idea of having an outside partner within the company, of losing absolute control," he says.
The Corporación Financiera Ambiental (CFA) --Central America's first venture capital fund and the only one that invests exclusively in small-scale environmental companies--also has had to slowly educate its clients. Since cfa began operations in July 1996, 120 investment projects have been presented to its Board of Directors, which has approved only eight.
"Many companies approach us with the idea that anything having to do with the environment implies soft money and donations," says Leonardo Ramírez, CFA's president. "The first thing we do is make them understand how our business works. Yes, we can take more risks than traditional banks, but the tradeoff is that the return on the investment has to be higher."
At the same time, Ramírez notes that because potentially successful businesses in sustainable development are often innovative in some way-- CFA's portfolio includes companies in such areas as renewable energy and sustainable forestry --mainstream financial institutions consider investing in them too risky. "The region needs new financial mechanisms like venture capital for companies that have excellent growth potential but depend more on their know-how, their market position, and their entrepreneurial and innovative capacity," Ramírez says.
Institutions such as the Multilateral Investment Fund and the Inter-American Investment Corporation, both members of the IDB Group, increasingly use equity as a development tool because it is profitable, sustainable and beneficial to the broader economy. It also uses the profit motive to bring accountability to the development process.
While a loan provides the lender with interest, returns on equity come in the form of dividends based on performance. So equity in essence makes investors accountable to the companies in which they have shares.
"We become partners from the moment we invest to the moment we exit," says FAPE's Blondet. "We can't just make an investment and then wait for the dividend check."